In late October, the market suddenly realized that the emperor had no clothes at MF Global (OTC: MFGLQ). And as revelers all over the U.S. gutted pumpkins in preparation for Halloween, the centuries-old brokerage was financially gutted as counterparties stepped away.
On Halloween, MF Global became a ghost itself, but the week prior to the bankruptcy filing was utter chaos for the company. As one former MF Global employee recounted, CEO Jon Corzine faced the distress head-on, pacing the trading floor and directing his troops in hopes of finding a way to save the company after the massive bet on European debt that he championed effectively doomed it.
Even as internal levers were pulled, MF Global hired investment bankers from Evercore (NYS: EVR) to work on finding a buyer with deep enough pockets to save the flagging broker. Most major financial companies thumbed their noses at the possibility of buying it -- they figured they could swoop in and pick over the pieces post-failure. However, heading into the weekend it looked like a deal would come together. Electronic-exchange-focused broker Interactive Brokers (NAS: IBKR) was at the table, and the talks looked promising. As an MF Global employee that was present for those final days recounted, "We all thought there was going to be a deal and we were going to be saved."
But at the eleventh hour, disaster struck. It was found that futures customer funds -- money which is legally required to be carefully set aside and clearly accounted for -- were missing. Initial media reports suggested as much as $1 billion was unaccounted for, but the number was quickly dropped to $700 million, then $600 million. But as far as the Interactive Brokers deal was concerned, the exact amount of the shortfall didn't matter one whit -- what was very clear was that a lot of client money had vanished. Buying MF Global was suddenly akin to buying real estate on Three Mile Island in late March of 1979. The deal was quashed and MF Global was left with no other choice than to file for bankruptcy.
Following the bankruptcy filing, it would take James Giddens -- the bankruptcy trustee of MF Global's broker subsidiary -- a full three weeks of working through the company's books to offer an "official" estimate of the shortfall. On Nov. 21, he announced that "$1.2 billion or more" had disappeared from the segregated customer accounts.
Whether we're talking about a bank, an equities broker, or a futures broker like MF Global, it's clearly bad when deposited customer money goes missing. However, there are safety valves for bank depositors and stock market investors. The Federal Deposit Insurance Corporation protects banking customers to the tune of $250,000. Meanwhile, the Securities Investor Protection Corporation steps in with up to $500,000 per customer to help equity investors when a stock broker fails and doesn't have adequate funds to make its customers whole.
There is no such insurance backstop for futures customers. What the futures industry has relied on instead are "segregated accounts" that put customer money in a safe side-pot that is legally off-limits for the broker to use to directly fund its operations or back its own proprietary trading positions.
Ask futures customers about segregated accounts, and nine times out of 10 they'll tell you that those accounts are sacrosanct.
Where's the money, Corzine?
The possibility that Jon Corzine authorized the customer funds to be pulled out of segregated accounts to plug holes in the company's balance sheet is in some ways a very logical scenario. As we've detailed in this report, Corzine created an atmosphere where serious challenges to his power and decisions were basically nil. In the turbulent scrum that took place as they tried to save the company, it seems even less likely that a Corzine directive would be denied.
This scenario would provide a tidy denouement for those of us breathlessly waiting for resolution. Corzine would be criminally culpable, civil suits could plunder his personal assets, and prosecutors could fit him for a new kind of striped suit and send him on a long vacation with Bernie Madoff.
This would also likely work out well for regulators, including MF Global's primary self-regulatory organization, CME Group (NYS: CME) . If Corzine acted criminally, it may let those regulators off the hook to some extent. It doesn't necessarily take a regulatory failure for somebody to act criminally. After all, robbery is illegal, but if a thief is bent on robbing a bank, he or she will do it anyway.
This seems to be the scenario that the CME is pushing -- according to congressional testimony from CME Chairman Terry Duffy and a timeline of events released by the CME, not only were there potentially prohibited loans made from customer accounts, but Corzine may have known about the loans. However, at the time of this writing, the CME's account was uncorroborated and the details were under wraps on who from MF Global was talking about Corzine's knowledge of the loans and what exactly was said.
And while there are those who think it inconceivable that Corzine would have acted illegally, times of extreme stress can often drive people to do things that they wouldn't otherwise dream of doing.
As cleanly as the Corzine-as-criminal scenario would wrap up the MF Global case, there are good reasons to doubt that's how it went down. Corzine was a wealthy and well-connected man, which promised him a perfectly comfortable life even if MF Global failed. And unless the former senator was willing to add perjury to his rap sheet, if he had criminally authorized the use of client funds, there's no way he would have said the opposite during multiple testimonies in front of Congress.
It's important to remember, too, that in a large, global organization -- financial or not -- the CEO is responsible for setting up the right systems and effectively delegating responsibilities.
This leaves open the very real possibility that, without his knowledge, somebody at a level well below Corzine made the decision to funnel client funds to the company's balance sheet in a desperate attempt to keep the ship from sinking.
This doesn't necessarily let Corzine off the hook, though. As noted above, it's a major part of the CEO's job to put the proper systems in place. In fact, regulations implemented through Sarbanes-Oxley -- a bill that Corzine co-wrote while he was a senator -- require that the CEO and CFO sign off on the effectiveness of the controls over financial reporting. For instance, for fiscal 2011, both Corzine and MF Global CFO Henri Steenkamp signed off on the fact that they had:
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities.
If those proper "controls and procedures" were in place, a breach of segregated client funds should have set off loud, blaring, obnoxious alarms that would have alerted management to that breach. If it turns out that those proper controls weren't in place, Corzine and Steenkamp could face both civil and criminal charges.
It's also possible that the proper procedures were in place, but an employee was simply determined to illegally circumvent those systems -- perhaps in some misguided belief that it would help save the company and curry favor with Corzine or other members of management.
Of course there's also the possibility that malfeasance isn't present here at all. Multiple former MF Global employees that we spoke to think that the missing money may simply be the result of a bookkeeping error. They believe it's unlikely that there was deliberate wrongdoing involved, particularly on the part of Corzine. Former MF Global trader Michael Fitzpatrick emphatically stated that he'd be "nothing less than flabbergasted" if it turned out Corzine did something nefarious. Even TV stock jock Jim Cramer -- who was a former Goldmanite himself -- stepped up to defend Corzine on CNBC, saying Corzine is "not a bad man."
To be sure, in the best of days the accounting and bookkeeping for a global brokerage firm is complex. And these were anything but the best of days for MF Global as it scrambled to pull out of a tailspin. News reports have quoted people close to the situation as describing MF Global's books as "a disaster." In testimony before the House Agriculture Committee, Corzine spoke to the chaos that reigned in the final days before the bankruptcy, and suggested that the amount of money that was shifted around could make things very difficult to pick through.
And yet the longer the process drags on, the less likely the "bookkeeping error" scenario seems. With forensic accountants and FBI investigators working with former MF Global employees to untangle the books, it seems highly unlikely that an accounting misstep -- or even a series of missteps -- would take more than a month to ferret out. Furthermore, while the CME's timeline shows that the missing funds were initially thought to be an accounting mishap, it notes that by the early morning hours of Oct. 31, MF Global reported to them that "the deficiency is real."
Flight of the red herring: Rule 1.25
In the wake of MF Global's collapse and, in particular, the revelation of the missing customer funds, a lot of focus -- particularly from lawmakers in Congress -- has been put on the Commodity Exchange Act's rule 1.25, which dictates the way in which futures brokers can invest customer funds. Much of the focus appears to stem from confusion over what exactly the rule means.
First of all, from a big-picture perspective, it's not unusual at all for a financial company to earn income for itself by investing customer funds. The entire banking business model is built on redeploying deposits in interest-earning investments, including mortgage loans. Equities brokers such as Charles Schwab (NAS: SCHW) can also invest customer cash balances to earn interest income. Even payroll giant ADP (NYS: ADP) invests customer funds during the short interval between when the client gives them the money and when it has to go out to tax authorities or the client's employees.
For futures brokers like MF Global, it is likewise permitted for them to invest customer funds to earn interest income. Rule 1.25 simply details what types of investments are kosher. The only reason that 1.25 should be an issue in the MF Global case is if there was reason to believe that overly loose parameters in the rule had something to do with the missing client funds. At the time of this writing, there has been no solid evidence that client funds had anything to do with the repo-to-maturity trade that led to the company's collapse, or that the missing customer funds have anything to do with overly risky investments that were permitted under 1.25.
In fact, it seems that the only reason that 1.25 is a hot topic among lawmakers -- besides their lack of understanding of what the rule is -- is that there was some appearance of fishy dealings around proposed changes to the rule prior to MF Global's collapse. Corzine and other high-level executives at MF Global had met with regulators from the Commodity Futures Trading Commission to push back on changes that would cut back on what was allowed under rule 1.25. Today, those meetings look sketchy in light of MF Global's collapse, but MF Global was one of several futures brokers that was campaigning against the rule change. Plus, just because Corzine was pushing back on the rule change doesn't necessarily mean that there was something underhanded going on -- in fact, it could be said that he wouldn't be doing his job as CEO if he didn't advocate for the company when regulations threatened to crimp the business.
Not that the CFTC has been helpful in clearing up the misunderstanding around rule 1.25. In a very desperate-seeming move after MF Global's collapse, the regulator passed the "MF Global rule" which went ahead with the previously considered changes and curtailed futures brokers' ability to invest in sovereign debt or borrow money from customer accounts via repurchase transactions. We believe that it will eventually be revealed that what was permitted under rule 1.25 was not the cause of MF Global's missing funds, which will also show that the CFTC's rush to implement the "MF Global rule" was a cheap ploy to save face and make it look like the regulator was doing something in response to MF Global's collapse.
And all of the rest
In our conversations with MF Global customers, former employees, regulators, lawyers, and other experts, it seemed at times that there were as many theories about the missing money as there are sweaters in Jon Corzine's closet. Some were simply variations of the scenarios presented above. Others were far more creative and sounded more like something out of a John Grisham novel.
With significant facts still yet to be uncovered, it's certainly possible that something surprising, or even bizarre, happened here. As they say, fact is often stranger than fiction. However, at the time of this writing, we believe that one of the scenarios presented above will eventually be proven by investigators.
But no matter what happened to the money, MF Global customers have had to deal with the fact that a huge amount of money is missing and much of the rest of their deposited funds were frozen for an extended period of time. This has created hardship for thousands of customers that were directly involved with MF Global. Furthermore, it has had a chilling effect that reaches much more broadly than MF Global, as futures traders all over the country wonder whether this might be a sign that the system is simply broken.
In the next chapter, we discuss who knew what and when. Click here to read all about it.
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